That’s what you need to beat the market and that’s what the Magic Formula is supposed to do.

As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.

Buy at least 20 stocks from the Magic Formula screening tooland then rebalance at the end of the year. Do this and you will beat the market, the book says.

Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.

Earnings Yield = EBIT / Enterprise Value

Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

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Earnings Yield is used because it targets companies with below-average prices. The idea behind of Return on Capital is to select good companies that are outperforming. This fits in line with what Greenblatt said

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Magical Performance

So how magic is this Magic Formula in terms of performance? This table of values is from the revised 2010 version of the book.

and a better representation.

Starting with $10,000 the Magic Formula would have made you a millionaire by 2009.

The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR has declined significantly. No strategy can sustain a CAGR of 30%. Although the backtest in the book only provides data up to 2009, I wouldn’t count on 2010-2012 results showing vast out-performance.

The Magic Formula is a Fraud?

By popular demand, the Magic Formula will soon be added to the list of value stock screens, but the one thing that has held it back is the reliability of the backtest performed by Greenblatt.

I just don’t believe the results are as good as it seems.

What’s more, other blogs have tried to simulate the Magic Formula performance from the book, but none of them have come close.

The method in the hands of Greenblatt’s Formula Investing Funds has had mixed results.His US funds (fvvax, fnsax) have both beaten the S&P 500 6 mo’s and 1 year ending May 20 but the rolling 2 year is only matching the S&P 500. If you had bought either fund on the day it opened, though (a month just outside the 2 year chart) you would have beat the S&P by 5 points cumulatively. His International funds have not done so well.

so in year 1 you buy in jan and sell in Dec. in year 2, you buy in jan. Dont you also sell in Dec in year 2 to buy in Jan in year 3 again? Why isnt it 40 trades a year? Cant seem to understand why you say it is only 20 trades from year 2 onwards.

I don’t get the re-balancing part. Magic Formula states that you sell both losers and winners. The only difference is WHEN you sell it. One week before or one week after the year mark. I believe that is due to the taxation benefits. In my country taxation is bit different. We pay 13% on capital gain and 9% on dividends in the given calendar year.BUTWhy selling all stocks after a year? Why not holding good stocks?MF also suggests thst you build your portfolio by adding 2-3 stocks a month. Suppose i start on January. By december I have around 30 stocks. Now it’s time for re-balancing. How do I pick winners and losers? I have 2-3 stocks that I purchased on January, 2-3 bought in Feb, etc. So how do I rebalance? Or should I rebalance on Dec next year after holding the whole portfolio for a year?Please explain this part.

7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period

I still don’t understand why sell both loosers and winners ..?8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

Does that mean that when rebalancing I keep only those stocks that appear in the screener. If none of the stocks from the portfolio show up in the screener, than I sell them all? And keep those that remain in the screener?So how he defines winners then? Those stocks that have positive capital gain after holding them for a year but disappearing from the screener should be considered as winners and must be sold?

I saw a presentation given by Greenblatt on the magic formula which explained how he constructed the portfolios for his backtesting. Greenblatt mentioned something which I didn’t pick up from reading his book, that is, that the backtesting involved the selection of 12 portfolios per year.Basically, Greenblatt ran the “magic formula” to select the 30 highest ranked companies for say January of 1990 – that portfolio would be held for around one year (as you noted in your post). However, Greenblatt then repeated the exercise for February 1990, March 1990 as so forth. So each of the annual return figures shown in Greenblatt’s book represents some kind of average for twelve simulated porfolios for the relevant year.Further, I believe that Greenblatt was aware of the criticisms made by Turnkey (and others), but Greenblatt chose to repeat the figures in the updated version of his book. To me, that suggests that Greenblatt was comfortable with the work he did, notwithstanding the criticisms or that the differences could be explained. For instance, I understand that the Turnkey work was based on portfolios selected from a universe of the 1,000 largest stocks by capitalisation; whereas Greenblatt’s backtesting involved a bigger universe.

I am also unsure how you would average in… If you only buy or sell once a year what do you do with all the funds you would accumulate to invest during the year? Are those supposed to sit in cash until you buy? Shouldn’t that return(or lack of) count towards overall performance?

you sell individual purchases after 12months. that means you sell and buy new stocks after 12 months every month…. ec if u bought P&G, Apple and McDonalds in Jan 2014, in Jan 15 u’ll sell only these 3 companies and buy 3 new to fill ur portfolio

Just started exploring the world of investing, and while I know I’m on the right track in terms of learning considering I follow your blog and some others. I find it overwhelming to see so many different criterias and screening styles and valuation equations available that seem to be doing a good job. I know I’m probably asking this question because I have missed some basic principles. Appreciate if you can help me out and direct me to how I would decide on which screens to pick and when. If there are books you may recommend that would help in the topic

Just an into this article, thanks for writing it. I was using the magic formula pre-2009 and would make enough on a few thousand dollars to pay my trading account:) I knew it would take time and more money. But my question is..I quit because the tax laws we about to change on capital gains. and you would be taxed more selling before or after a year. Those laws changed right? I didn’t think you would make any money with the higher tax rate. I thought that was the whole point. thoughts on the MFbefore and after tax law changes? thank you.

The think with taxes is that it’s different for other people. If you can offset it somehow, that works out.If you do it via a non taxable account, you can continue growing it.Just depends on your situation.

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